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The UK could soon see stricter rules around CFDs

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The UK could soon see stricter rules around CFDs

One path to profit in financial markets is to understand the cognitive biases that can make investors behave irrationally, and take advantage of their mistakes.  For example, when prices are pushed out of alignment by panic selling or euphoric buying, a measured investor can try to benefit by taking the other side of the trade.

However, while reasonable among consenting adults, this idea has some moral limits attaching to it.  At some point, taking advantage of a poorly-informed or unskilled counterpart begins to look unseemly.

It is with this in mind that the Financial Conduct Authority (FCA) in the UK has taken a look at, and proposed stricter rules for, firms offering contracts for difference (CFDs) to retail consumers. (CFDs are a form of derivative trading that enable you to attempt to net a potential profit by speculating on the rising or falling price of shares, indices, commodities, currencies and treasuries.)

CFDs have an entirely legitimate place in financial markets, but they are complex products that are often traded with high rates of leverage, thereby allowing investors to trade large volumes (and assume large risks) with limited capital.

Often, a CFD provider will provide helpful trade ideas and strategies to encourage clients to be more active.  It is no doubt tempting for clients to follow the recommendations of someone who claims to have trading expertise, and who can back this claim up with anecdotes of successful past trades.

This is clearly an attractive setup for the CFD providers who profit from the volume traded by their clients.  For the retail clients who may not have a firm grip on the markets or instruments they are trading, however, the benefits are a little less clear.  Human bias being what it is, these clients will often assume that they have the skill, judgement and dynamism to make easy money by aggressively trading these instruments.

And this, it turns out, is their undoing. The FSC has analysed a sample of client accounts for CFD firms to work out how well those clients have been doing. They found that 82% of clients lost money: a remarkably poor success rate that few informed investors would consider attractive.

Improved regulation and disclosure will no doubt help protect these investors from themselves, but one suspects the FSC has a big job ahead of it if it wishes to eliminate irrationality from this part of the market.

Tim joined Montgomery as Head of Research and Portfolio Manager of The Montgomery Fund in July 2012. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Before joining Gresham Partners, Tim worked for McKinsey & Company for four years, where he was involved in strategic consulting in both Australia and Denmark.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

3 Comments

  1. This may sound callous, but sorry, I have no sympathy if retail investors lose their shirt because of CFDs. If you trade CFDs or Forex because it’s exciting and you expect to “get rich quick”, don’t be surprised or blame anyone else if it blows up in your face. No one is forcing you to use leverage.

    If people are stupid or greedy enough to use CFDs with all the leverage that they involve, then it is their own fault. No one stops them using the roulette wheel in the casino in the same way for red vs black, so why is this any different ?

    I personally don’t use CFDs because I don’t understand them and don’t want to. I know what they can do and that losses can also be virtually unlimited. No thanks.

    To me, the leverage is the equivalent of repeatedly driving your car down a dark road in the rain and in excess of the posted limit, then expecting to come out unscathed because remember, there’s always someone bigger and heavier than you out there in the sharemarket who can shift things against you.

    Oh yes, there’s “stop losses” I hear you chime, but I’ve heard stories where the position has moved against someone so rapidly that they haven’t kicked in. Much like the brakes on a car, they are not foolproof and I doubt a provider would underwrite a massive loss, just because a stop-loss had not worked…they would have some loophole in the PDS to avoid that happening.

    People should take some personal responsibility and stop expecting the Government to always look after them ! Why is it always the Government’s fault that people act like fools ? You cannot legislate against stupidity. If you are daft enough to treat the sharemarket like a casino and do your dough, I regard that as natural selection.

    • Your comments are fair up to a point Chris. I my own irritation after the GFC when the usual squeaky wheels who cry poor after falling victim to their own greed sought compensation, even if that had to come from fellow taxpayers.

      That said, the stories which came to light following the failure of a high profile financial planning firm demonstrated that there were clients whose level of education wealth, and relevant experience should have warned them to stay well away. On the other hand, there were some of modest means who evidently had little experience in financial matters and probably genuinely trusted the ‘advice’ they were offered.

      It is for this latter group more than the former that Governments do need to play a protective rule via rules and regulations.

      Alas, we are not all born into, nor find ourselves the beneficiaries of an equal set of circumstances in life.

  2. “A fool and his money are soon parted.” If they don’t buy CFDs then they will find something else. Binary options anyone?

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